January 9, 2010

China must live with hot money – or revalue

Hot money is on Beijing’s hit list. Unexplained inflows of foreign currency roared back during 2009, to maybe $200bn.

While policymakers gripe – a senior official railed against speculative money earlier this week – this is the result of their decision to keep China’s currency cheap.

If Beijing won’t revalue the yuan, the best it can do is scramble to close some of the loopholes through which hot money flows.

Speculative capital – defined as foreign money not accounted for in official trade and investment data – generally chases the idea that the yuan will be revalued. Beijing doesn’t like it for two reasons. First, because it is helping fuel the asset price boom which saw stocks rise 78pc in 2009 and property prices increase 20pc.

Second, hot money is putting yet more pressure on the yuan to appreciate. To counteract that, the central bank has to print more money – and, to stop that turning into inflation, it then has to issue bonds to soak up the money.

That doesn’t just cost in terms of paying coupons; it means that the domestic banks, which get arm-twisted into buying the bonds, have their balance sheets clogged up with low-yielding assets.

A sharp revaluation of the yuan would stop speculative flows. A researcher at a state think-tank called for a 10pc one-off hike on Wednesday. Yet with exports still falling year on year, the government may feel it cannot take such drastic measures now.

That leaves Beijing fighting to plug holes in the system. Last year, some 44 illegal exchanges in the border city of Shenzhen shifted $3.5bn across the border, according to a government statement this week. Those exchanges have now been closed – and presumably there can be a crackdown on other similar ones.

Another popular trick is the creation of fictitious export receipts in order to bring in illegal foreign money. A domestic exporter might, for example, pretend to sell pencil sharpeners to a Hong Kong investor. That would be used as a cover for the investor to pass over dollars that could then be converted into yuan. Beijing’s constant efforts to root out the fiddling of company accounts might help to close this loophole a bit – but don’t expect miracles.

Ultimately, hot money is a choice. If China won’t revalue the yuan, foreign inflows will keep driving up asset prices. But if the bubble bursts, Beijing may discover that money finds a way out just as quickly as it found a way in. That would take pressure off the yuan but land China with all the social costs of a collapsed bubble.

Then there are the skeptics that forecast an economic crash in China. James Chanos, a wealthy hedge fund manager is leading this chorus, “warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.’ ”

While this view is gaining some traction, it is still relegated to the minority. Investors and economists are now operating under the firm assumption that China will allow the RMB to resume its appreciation soon. As for when, it could be any day, though probably not for a few months still. As for the questions of how and to what extent, some economists have argued for a one-off appreciation (10% has been suggested) in order to discourage future inflows of speculative capital. Most analysts, though, expect the rise to be gradual. Futures prices currently reflect a 3% rise over the next year, and the consensus among economists is similar. It also depends on how the Dollar performs over the near-term: “If better-than-expected growth in the U.S. helps the greenback recover this year…That would take some of the pressure off Chinese policy makers.”

Personally, I think expectations of a 3-4% rise over the next twelve months are pretty reasonable. The Chinese government doesn’t have much to gain (neither politically nor economically) from a rapid appreciation in the currency, so if/when the RMB rises, it will probably only be in “baby steps.”